Over-reaction and investment decisions

The  majority of investors tend to formulate investment strategy by naively extrapolating recent trends. Second, they tend to be overconfident in their ability to predict the immediate future accurately. Finally, their confidence intervals are skewed, which means their best guesses are not evenly spaced between their high and low estimates. Why does this happen? In effect, individuals are most influenced or tend to ‘anchor’ their predictions on just how salient they believe recent history is. Nobel Prize winner Daniel Kahneman suggested that we tend to judge the probability of an event by the ease with which we can call it to mind. The more vivid our memory of something similar in the past, the more probable it will seem to happen again. Remember 2008 — AIG, Lehman Brothers, Bear Stearns.

Paul Slovic, psychologist has an explanation that is based on our intuitive sense of risk being driven by two factors — dread and knowability. His conclusion: These two factors ‘infuse risk with feelings’. Dread is really a function of how dramatic, controllable or potentially catastrophic a risk appears to be. The knowability of a risk depends on how immediate, specific or certain the consequences appear to be.

Therefore, our perceptions are distorted such that we underestimate the probability and severity of common risks such as inflation. On the flip side, less comprehensible risks that we have never personally experienced seem potentially lethal. As Jason Zweig put it, “We see the world through warped binoculars that not only magnify whatever is remote, but shrink whatever is near.” So, blinking in the face of risk might well be natural, yet the over-reaction is incredibly dangerous in arriving at investment decisions.
 
The financial media seems to revel in highlighting the current woes of the stock market with laser-like precision — the interminably long list of new 52 week lows, faltering corporate earnings, the soaring price of gold and the incredibly muddled response of policymakers around the globe. So, does financial holocaust beckon just round the corner or are there signs that the deathly pall of gloom might lift within the next two or three quarters?

Your Money and Your Brain

•  our investing brains often drive us to do things that make no logical sense—but make perfect emotional sense. That does not make us irrational. It makes us human. Our brains were originally designed to get more of whatever would improve our odds of survival and to avoid whatever would worsen the odds. Emotional circuits deep in our brains make us instinctively crave whatever feels likely to be rewarding—and shun whatever seems liable to be risky.

•  To counteract these impulses from cells that originally developed tens of millions of years ago, your brain has only a thin veneer of relatively modern, analytical circuits that are often no match for the blunt emotional power of the most ancient parts of your mind. That's why knowing the right answer, and doing the right thing, are very different.

•      "Financial decision-making is not necessarily about money It's also about intangible motives like avoiding regret or achieving pride." Investing requires you to make decisions using data from the past and hunches in the present about risks and rewards you will harvest in the future—filling you with feelings like hope, greed, cockiness, surprise, fear, panic, regret, and happiness

•   There are three kinds of investors: those who think they are geniuses, those who think they are idiots, and those who aren't sure. As a general rule, the ones who aren't sure are the only ones who are right.

•   Monetary loss or gain is not just a financial or psychological outcome, but a biological change that has profound physical effects on the brain and body. Financial losses are processed in the same areas of the brain that respond to mortal danger.

•     expecting both good and bad events is often more intense than experiencing them.

•   our intuitions can often mislead us, he fails to emphasize that our intuitions about our intuitions can be misleading. Among the most painful of the stock market's many ironies is this: One of the clearest signals that you are wrong about an investment is having a hunch that you're right about it. Often, the more convinced you are that your hunch will pay off big, the more money you are likely to lose.

·                      The best financial decisions draw on the dual strengths of your investing brain: intuition  
             and analysis,   feeling and thinking

 Your investing brain the reflexive (or intuitive) system and the reflective (or analytical) system.

The reflexive system: 

• (which some researchers call System 1) gets "first crack at making most judgments and decisions,".   We  count on our intuition to make initial sense of the world around us—and we tap into our analytical   system only when intuition can't figure something out., "We run mostly on System 1 software."our brains can't possibly keep up with everything that's happening in our environment. Whenyou are at rest, your brain—which accounts for roughly 2% of the typical person's body weight—consumes 20% of the oxygen you take in and the calories you burn. Because your brain operates at such a high "fixed cost," you need to ignore most of what is happening around you. The vast majority of it isn't meaningful, and if you had to pay separate, equal, and continual attention to everything, information overload would fry your brain in short order. "Thinking wears you out,".  "So the reflective system tends not to want to do anything unless it has to."  
  
  Therefore, our intuition acts as the first filter of experience, an instantaneous screen that enables us to conserve our vital mental energy for the things that are most likely to matter. Because of its phenomenal skill in recognizing similarities, the reflexive system sounds an instant alarm when it detects a difference.

Reflexive system is so fixated on change that it makes it hard for you to focus on what remains constant.( your reflexive system will prompt you into paying more attention to a single stock rising like a rocket or sinking like a stone than the much more important (but less vivid) change in the overall value of your portfolio)

The reflexive system this way: "It's kind of like a guard dog. It makes rapid but sort of sloppy decisions. It will always attack the burglar,but sometimes it might attack the postman,
too."

The Reflective Brain 

The reflective system may rely on what they call "tree-search" processing.
   
In the financial markets, people who rely blindly on their reflective systems often end up losing the forest for the trees—and their shirts as well.  There's always something to measure on Wall Street, which spews out a torrent of statistics on everything under the sun 

If the reflective system can't readily find a solution, the reflexive brain will resume control, using sensory and emotional cues as shortcuts. 

you need only to understand that the most reliable way of determining whether something is true is to try proving that it is false.